PrefBlog

The Fed cut by 50bp today, giving equities a big boost at the expense of long bonds and the greenback. As justification, their statement said:

Today’s action is intended to help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets and to promote moderate growth over time.

Readings on core inflation have improved modestly this year. However, the Committee judges that some inflation risks remain, and it will continue to monitor inflation developments carefully.

 For those keeping score, a handy guide to predictions of the Fed move by the brokerages houses was compiled by the WSJ Economics blog. Post-event reactions ranged from ‘Bold!’ to ‘Irresponsible!’. Tom Graff at Accrued Interest supplies an interesting prediction for the next two years.

James Hamilton of Econbrowser noted:

The Fed deliberately took a step back from its longer-run mission of containing inflation today. I don’t think Bernanke did so because he’d like to see 3-1/2 instead of 2-1/2 percent real growth next year. I’ve been saying all along that his intention is to squeeze inflation as much as possible without sending the economy into recession or financial crisis.

The verdict is still out on whether we’ve avoided one or both of those last two pitfalls. If we have, I’m not sure that the market’s confidence in another 50 basis points of cuts is warranted. If we haven’t, today’s exuberance in equity markets cannot be rational.

Well, US Core PPI looks OK anyway!

Over the past 12 months, producer prices rose 2.2 percent, down from a 4 percent increase in July. The year-over-year increase in costs excluding food and energy also eased to 2.2 percent compared with 2.3 percent in July.

In a highly interesting Canadian ABCP development, it looks like Dundee Bank flamed out:

Scotiabank will pay C$260 million in cash for Dundee Bank, a small bank that had been raking in deposits but was recently shaken by its exposure to a troubled corner of Canada’s asset-backed commercial paper sector, a short-term debt market that ground to a halt last month.
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That was even after DundeeWealth said it will realize a net loss of about C$70 million on the sale of Dundee Bank “as a result of certain investments that are currently being valued below initial cost.”
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DundeeWealth revealed on August 23 that the group was holding about C$400 million of commercial paper, instruments that are currently locked in a moratorium while the biggest players in that market try to hammer out a solution to prevent defaults.

I’d love to have more details on this. $70-million is an awful lot of mark-down on a $400-million position that, by all accounts, is reasonably well-secured with underlying assets anyway (albeit of a much longer term than originally intended). I wonder what else is going on with them? According to my interpretation of today’s DBRS rating confirmation, the problem was that they simply can’t place the money that has been deposited with them:

Aside from not yet achieving ongoing profitability, the Bank’s business model had become somewhat constrained given the recent credit market disruption. Without a lending operation, the Bank was relying on investments in collateralized loan obligations (CLOs) and asset-backed commercial paper (ABCP) to support its deposit liabilities, a strategy that is no longer practicable in the current market. The Bank grew to about $2 billion in assets since it began operations in September 2006.

Dundee Wealth has a ten-year retractible, DW.PR.A, in the preferred share market, rated Pfd-3 by DBRS. The issue soared on the news, presumably on market speculation that it is effectively an obligation of Scotiabank now and therefore of much higher quality.

Does everybody remember my speculation about the possibility of  a spectacular flame-out if a large bank suddenly discovered its risk controls weren’t exactly perfect? Looks like one shop, anyway, has come close:

Calyon, the investment banking arm of France’s Credit Agricole SA, said third-quarter profit will be “sharply down” after an unauthorized proprietary trade cost the bank 250 million euros ($347 million).

Calyon discovered an “unusually large market position” on diversified credit market indexes at its New York unit on Sept. 4, the Paris-based company said in a statement today. The trade, which breached authorized limits, has no relation to the subprime mortgage market, the bank added.

And, finally …

US Equities roared upwards after the Fed rate cut, as did the Canadian market.

Treasuries pivoted:

The difference in yield, or spread, between two- and 10-year notes widened to 0.5 percentage point, the most since Aug. 21. The gap was about 0.38 percentage point before the Fed statement.

Always remember: the short end trades on monetary policy while the long end trades on inflation expectations (the 10-years trade on futures & mortgage hedging!). One of the most educational graphs I’ve ever seen was of the Gilt market for a period of some years in the ’90’s … a beautiful, huge, smooth pivot, centered on the 10-year which barely moved.

Canadas pivoted.

The preferred share market continued its quiet ways. Volume continues to be light; entertainment was provided by the DW.PR.A mentioned above.

There were seven other $25-equivalent index-included issues trading over 10,000 shares today.

Panic, thy name is retail:

Despite the credit-market uproar, redemptions from money market funds were described as lower than expected at $915.5 million. Bond funds had $368.1 million in net redemptions excluding reinvested distributions, and Canadian equity funds had net redemptions of $578.4 million.

The only positive major category was balanced funds, offering conservative managed combination of stocks and fixed-income holdings. Canadian balanced funds endured $271.5 million in net redemptions, but the global balanced segment showed net sales of $670.5 million.

I’m sure that somebody, somewhere, has studied mutual fund cash flows vs. 12-month future returns. If anybody knows where I can find such a thing, let me know and I’ll post the link.

The Northern Rock crisis continues in Britain, with the stock dropping, customers crowding the withdrawal window and the Bank of England’s actions being questioned. The part I don’t understand is:

Northern Rock credit-default swaps increased 15 basis points to 170 basis points, according to JPMorgan Chase & Co. The cost of the credit-default swaps, which traded as high as 210 basis points on Sept. 14, rises as creditworthiness deteriorates.

Only 170bp? You don’t have to look very hard to find higher prices than that in the North American markets … Countrywide & CIT Group are quoted in the mid-200s, for instance, and with all their problems they’re not actually suffering a run and getting publicly announced support from the Fed. Bear Stearns & Lehman are in the low-100s. Still – I haven’t actually looked at NR’s financials, so I’ll just pass on the tidbit without further comment.

But! After the UK markets closed, the following announcement was made:

The British government is to guarantee all existing deposits at troubled bank Northern Rock, Treasury Chief Alistair Darling said Monday.

People can continue to take their money out of the Northern Rock, but if they choose to leave their money in the bank it will be guaranteed safe and secure,” Darling said at a Downing Street press conference.

Now, that is a bail-out. I don’t know what to make of it … but my gut reaction is unfavourable.

Meanwhile, in LBO news … Blackstone might be getting a black eye:

PHH Corp., the mortgage lender and vehicle-fleet manager that agreed to be bought by General Electric Co. and Blackstone Group LP, said the sale may unravel after Blackstone failed to get $750 million in loans.

And Credit Suisse is taking a hit on First Data:

Credit Suisse, the lead arranger of financing for First Data Corp.’s LBO, last week agreed to lower the amount of loans that banks initially will sell to $5 billion from $14 billion, and cut the price to 96 cents on the dollar, said three people with knowledge of the talks. The discount alone could cost about $200 million.
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Deutsche Bank AG, Germany’s biggest bank, and JPMorgan, the No. 3 U.S. bank, found buyers last week for the highest-yielding loans financing KKR’s purchase of U.K. pharmacist Alliance Boots. The banks had abandoned selling 6 billion pounds ($12 billion) of mostly senior loans in August because buyers weren’t interested.

Investors agreed to buy the loans at 95 cents on the dollar, according to bankers.

That concession followed the sale of loans to back the purchase of Allison Transmission, the Indianapolis-based auto- parts supplier, by Carlyle Group and Onex Corp. Banks led by Citigroup, the biggest U.S. bank, sold $1 billion of loans for the Allison purchase for 96 cents on the dollar.

The fact that these loans are moving at all, albeit at a hefty discount, will be welcome news for holders of BCE Prefs. BCE common was down a tad today, but well within the boundaries of random jiggle-jaggles.

Oil prices set a new record today, which might have long term implications for the Gulf states:

It should go without saying that the strong oil/ weak dollar mix creates real problems for all the Gulf countries that insist (still) on pegging to the dollar.   They are effectively importing a weak currency and low nominal interest rates when there economies are booming.   The result: massive inflation and very negative real rates that are adding to the boom now, but risk creating problems later.

Three income trusts have celebrated oil’s rise by cutting their distributions:

Income-trust distribution malaise spread through the oilpatch Monday as Enterra Energy Trust (TSX: ENT-UN.TO) suspended its payout while Wellco Energy Services Trust (TSX: WLL-UN.TO) cut its distribution in half.

Those moves followed a 10 per cent distribution reduction Friday by Pengrowth Energy Trust (TSX: PGF-UN.TO) and extended a wave of payout disappointments for investors, particularly in energy services trusts.

NovaStar, mentioned here on September 4 is in the news again:

NovaStar Financial Inc., the subprime home lender trying to survive by conserving cash, scrapped plans to pay a dividend on 2006 profit and will forfeit its real estate investment trust tax status as a result.

The mortgage company, one of more than 110 that have halted lending or left the business since the start of 2006, said in a statement that the loss of REIT status will have a “significant adverse impact” on third-quarter results. Kansas City, Missouri- based NovaStar is reviewing its listing requirements with the New York Stock Exchange.

“Clearly, we did not anticipate the drop in market value or the level of demands on liquidity caused by the market turmoil this summer,” said Chief Executive Officer Scott Hartman in the statement. “Canceling the previously planned dividend is the only reasonable and prudent course of action.”

James Hamilton of Econbrowser thinks enormous pressure for increased regulation is inevitable – and, at least to some degree, desirable. Econbrowser’s other principal, Menzie Chinn, notes:

As social scientists, we should try to explain why the current Administration behaves in this manner. One approach is the capture and ideology perspective of Kalt and Zupan (1984). Although not directly applicable (since their study was of legislative actions), the framework is of interest. If policy is captured by economic interests, then analysis is irrelevant. If ideology is paramount, then again analysis is irrelevant.

Oh, it’s a glorious world, where evidence, argument and analysis are irrelevant!

US Equities were off a bit, having run aground on the Northern Rock (and a sudden realization that maybe the Fed doesn’t actually have to cut by 50bp tomorrow if they don’t feel like it); Canadian equities followed.

Short-term Treasuries also fell, flattening the curve; Canadian ten-years rose, flattening the curve.

Preferreds didn’t do much on low volume, although the SplitShare and InterestBearing sectors drifted up a bit.

There were four other $25-equivalent index-included issues trading over 10,000 shares today.

Retail Sales in the US were unexpectedly weak in August, adding to the rationale for a Fed Rate cut (although the numbers are considered highly adjustable by some). Tom Graff uses a Taylor Rule (parameterized as a trading indicator, not as a policy gauge) to estimate the future Fed Funds Rate as 3.75% down 150bp from current, while emphasizing that he considers it a qualitative measure of direction, rather than an actual prediction. Fed Funds Futures are now predicting a value of about 4.5% at year-end. The use of the Taylor rule to determine neutrality – and the effects of getting it wrong – was discussed at the recent Jackson Hole conference. Economic chatter leans to a 25bp cut.

It will be most interesting to see the reaction of USD LIBOR and USD CP rates to whatever the Fed ends up doing. There are definite indications that USD ABCP investors are anticipating a rate cut – perhaps the next weekly Federal Reserve report on ABCP will not show such a huge decline. That will annoy the banks! Cushioning fear-driven liquidity shocks is their bread and butter:

This paper argues that banks have a unique ability to hedge against market-wide liquidity shocks. Deposit inflows provide funding for loan demand shocks that follow declines in market liquidity. Consequently, one dimension of bank “specialness” is that banks can insure firms against systematic declines in market liquidity at lower cost than other financial institutions. We provide supporting empirical evidence from the commercial paper (CP) market. When market liquidity dries up and CP spreads increase, banks experience funding inflows. These flows allow banks to meet increased loan demand from borrowers drawing funds from pre-existing commercial paper backup lines, without running down their holdings of liquid assets. Using bank-level data, we provide evidence that implicit government support for banks during crises explains the funding flows.

From the same paper, incidentally:

Banks’ functioning as liquidity insurance providers originated early in the development of the commercial paper market. In 1970, Penn Central Transportation Company filed for bankruptcy with more than $80 million in commercial paper outstanding. As a result of their default, investors lost confidence in other large commercial paper issuers, making it difficult for some of these firms to refinance their paper as it matured. The Federal Reserve responded to the Penn Central crisis by lending aggressively to banks through the discount window and encouraging them, in turn, to provide liquidity to their large borrowers (Kane, 1974). In response to this difficulty, commercial paper issuers thereafter began purchasing backup lines of credit from banks to insure against future funding disruptions (Saidenberg and Strahan, 1999).

David Dodge is quoted in The Economist as saying:

He acknowledged that the Bank of Canada may itself have played a role in stoking the excesses by not raising interest rates enough. “One can see in retrospect that we should have been driving those rates harder than we did, because in reality credit conditions were being eased by increased securitisation and movement of stuff off balance [sheet],” he says.

Presumably, therefore, decreased securitization and movement of stuff onto balance sheet is a de facto tightening.

Meanwhile, China is hiking rates due to inflation concerns. There is evidence that the effect of high levels of imports from China is shifting to inflationary from deflationary. And Brad Setser is puzzled about the current account deficit and how it relates to the investment income balance:

Since the US has a borrowed a lot more – about $ 5 trillion more — than it has lent out, mathematically, a constant deficit on the interest balance implies that either that the interest rate on US lending has to be rising faster than the interest rate on US borrowing or that the interest rate on US borrowing has to be falling faster than the interest rate on US lending.

If I did all the calculations correctly, it turns out that the implied interest rate on US lending has been constant (at around 4.7%) while the implied interest rate on US borrowing is actually falling, from a bit under 4.4% in 2006 to 4.25% in the first half 2007.

The Credit Rating Agencies are beginning to take a little more action to polish their public profile. Moody’s has published some reflections on liquidity and flight to quality, and promise more. They note:

The need for a liquid and transparent secondary market for structured product may delay a recovery in primary issuance as investors will avoid purchasing an asset in the primary market if a similar asset can be purchased in the secondary market at a lower price. Therefore, greater transparency will be required of the secondary market as well as lower prices (or better protection) in the primary market. The liquidity risk premium is going to be higher and investors will be reluctant to buy these products unless there is some degree of standardization and secondary market liquidity. Marked to market actors may be reluctant to buy customized product, and higher risk premia could temporarily reduce the economic attractiveness of securitization for certain classes.

Illiquidity was highlighted as one of six “key vulnerabilities” of the UK financial system in the Bank of England’s Financial Stability Report of April 2007:

Unusually low premia for bearing risk, especially in credit markets. Benign current economic conditions, the greater dispersal of credit risk and confidence that market liquidity will remain high may have weakened risk assessment standards. If risk perceptions were to adjust, unexpectedly large shifts in market liquidity might lead to sharper asset price changes than anticipated by market participants, with knock-on effects on counterparty credit risk.

The moral of the story is: liquidity is a risk! Investors may intend to buy and hold but the consequences of having to sell (or wishing to sell due to credit concerns) into an illiquid market can be severe. The best defense is, as always, a broadly diversified portfolio with the individual elements bearing a wide variety of risk/reward profiles. Just look at HSBC: what they’re losing on sub-prime, they’re making up on insurance.

Thomson, issuer of the TOC.PR.B floaters, has been downgraded by Moody’s from A3 to Baa1. Moody’s did not specifically address preferred shares; I believe they have a mandate only for Thomson’s USD debt.

BCE holders will be interested in the latest news from junk-land. Prices on TXU and First Data common have gotten closer to the deal price on hopes that financing will not kill the deal. Several others have also narrowed, but poor old Sallie Mae is a wallflower, now that Dad’s cutting her allowance. The First Data bond deal is getting done, albeit at a spread almost 100bp more than originally intended, with more restrictive covenants. Investment grade issuers are issuing lots of paper, swallowing the high spreads; presumably they are calculating their spread to some kind of ‘non-panic’ government yield rather than actual market levels.

US Equities finished a great weak on a quiet note; as did stocks in Canada. Both Treasuries and Canadas were boring.

Volume in preferred shares was extremely light, which is leading to some strange pricing moves. The market looks quite sloppy, although now that the BCE issues are acting a little bit more like Pfd-2(lows) again, my curve-fitting is showing reasonable goodness-of-fit. It’s one of them conundrum thingies!

There were NO other $25-equivalent index-included issues trading over 10,000 shares today.